The Big Wave Trading Portfolio is under a full-on SELL signal following the strongest signal received since the year 2012. While the signal did get a shakeout back to NEUTRAL the past week the overall weighting of the SELL signal remained. Following Friday’s major sell off the extremely strong SELL signal is back in full force.

The sell off on Friday was ugly, hit every major non-defensive sector, and had confirmation volume in every index and underlying index ETFs. The sell off on Friday was made worse with the breakdowns in Semiconductor stocks and the beginning of a breakdown in Bank stocks. If the Bank stocks breakdown you can be 100% sure we will be in a full on correction mode in the indexes. As far as I am concerned based on all the mathematical evidence that was presented last weekend along with the price action this is all but a given.

One item that was not discussed last weekend but was brought to my attention is the NYSE margin debt. A quick look at these charts below and I think it is pretty clear where we stand in terms of where we are at historically in this rally.

Now that you have taken a look at that chart let’s review everything I posted last weekend as all arguments made then are true today and are even more so following Friday’s action:

For the first time, the leading stocks are in defensive industries like Utilities and REITs. Now that the market is weakening again these continue to lead, along with other bear market leading sectors Food, Aerospace/Defense, and Energy. These are not the sectors you want to see leading if you want the market to hit new highs in the short-term. You obviously want to see leading industry groups rotate into other leading industry groups. We are definitely not seeing that this time around.

In fact, we are seeing them get punished severely. Cloud computing, Biotech, Solar, Social Networking, and 3D-Printing stocks are all getting hammered. None of these sectors are holding up and all are selling off on very heavy volume. No stock is being left behind. The only stocks not being left behind are those defensive stocks.

Which now brings me up to this. This entire uptrend from the 2008 lows has been insane. This entire rally has had some to do with corporation bringing to market amazing products but we all know the real reason this market is up near all-time highs and that reason is QE. Without QE, there is no way in hell we would be here. In fact, if anything, QE has made the current environment the most dangerous ever for investors. Asset prices have been inflated due to low rates and funny money. Without this, I am sure the 2008 downtrend would have longer, more painful, yet would have led to a real economic recovery rally. However, it didn’t happen so here is where we are.

We are now in a market where investor bearish sentiment on the Investors’s Intelligence survey is at a point not seen since before the October 1987 crash. The VIX, despite the market being below the recent February/March levels, is lower than where it was during our last pullback. This clearly shows that investors are complacent and think that stocks are safe to continue to buy here despite the recent selling. Definitely concerning.

However, that is not as concerning as the issue of the Fed. We have a Federal Reserve that has made it clear raising interest rates will be there on their agenda. On top of that, tapering is in effect in the tune of $10 billion per month. So the one thing that helped keep this market afloat for over five years is going to be systematically taken away. Treasury markets already see this coming and that is why we see rates rising on the long-end.

Other problems that have started to arise that I noticed in 2000 and 2007 include IPOs coming to market that have no business coming to market. We recently saw CSLT and KING prove to the market that the time has passed to make quick big gains in “hot” companies with questionable fundamentals. And we still have many more coming with BOX coming out shortly. When you see IPOs of this quality start to flood the market, you know banksters are just flooding the market with terrible merchandise while they can. The door is quickly closing shut to get these deals to market. This happened in 2000 and 2007 and here we are again. No lessons have been learned but that is the point of the game.

Then we have the crazy action we saw the past week with Facebook buying Oculus VR company. This news sent OCLS and OVTZ two stocks with the name Oculus in it ripping higher. This happened in Twitter’s IPO (TWTRQ), Google’s NEST acquisition (NEST), and now Facebook’s Oculus purchase (OCLS & OVZT). See a pattern. This is not a market driven by real fundamentals. It has become a speculative joke.

Getting back to debt, distressed debt is exponentially climbing, articles about taking out a second mortgage to buy stocks, and the fear in the RE rental market in SF and NYC brings to mind the fear that RE renters faced in 2005-2007 before the bubble burst. So there are other signs outside of the actual stock market that suggest something is brewing.

Now while all of these problems in our economy have been apparent for a while it is just now starting to really pick up steam we had price hitting new highs and leading stocks leading us higher. Now we still have all of these problems and this time around we have no leaders to help us off the floor. At least not yet and that is exactly the problem.

The biggest problem in reality is that no matter which way you slice it (price-to-sales, price-to-earnings, sales-to-earnings, etc…) this market is one of the most expensive ever following the Q1 earnings season. Only 1929 and 2000 saw a more expensive market. Let that soak in for a little while.

So while it is certainly ugly out there and all (well almost all) our long-term best performers have been sold we still are finding a few actionable long signals in those stocks that are leading in defensive industries. We have recently taken some Energy, REIT, and Utilities long that are working. If these signals continue to generate, we will continue to take them, even if the market is choppy or down trending. Even in this market, a signal is a signal is a signal. We have had many successful long side plays in the past when markets were weak (2000-2002 and 2008) so we will not be afraid to take them here. However, they will be VERY small positions in terms of our total capital.

The best news about this action is that it sets us up for a correction where we can finally get leading stocks to find a reasonable valuation level to begin to build a floor to rally from. This will allow us to increase the size of our new long positions to our usual 10-20% per trade stakes that we have not been able to do for a very long time due to the inability of this market to even pull back 20% since the 2008 lows. It’s been an odd uptrend for sure but it finally looks like it is running out of long-term steam.

If all of this analysis is wrong and we reverse higher on huge volume with leading stocks breaking out, do you think we will marry the above analysis? If you are a regular reader of this blog you know the answer. Aloha and have an amazing weekend!!